Ratings agency Fitch upgraded Russia to one notch below investment grade last
week, but thanks to its fast economic growth, bond traders are already pricing
Russian debt as if the country was a fully functioning market economy.

While the rest of the world struggles to stave off recession, Russia has gone
from strength to strength. President Vladimir Putin said in his state of the
nation speech on Friday: "Russia credit rating is now at its highest level
in history. We have some of the biggest companies in the world in their sectors,
and they are expanding and starting to offer serious competition to those of
other countries."

Mr Putin pointed out that the Russian economy has grown by 20pc over the past
three years, its first robust growth for three decades, and called for a
doubling of economic output by 2013.

"This is realistic, though very difficult," Mr Putin said.
"The doubling of the GDP is a large-scale task. It will require a deep
analysis, including of the existing approaches to economic policy," he
said.

The financial crisis of 1998, when Russia became one of the few countries in
history to default on domestic debt and the rouble was devalued, was the turning
point. Prior to devaluation of the rouble, companies could not compete with
imports and the government failed to collect taxes from impoverished firms.

With the rouble cut to a quarter of its value against the dollar on August
17, 1998, imports disappeared overnight and domestic producers stepped gleefully
into the pounds 20 billion hole.

Shortly after coming to power in May 2000, Mr Putin pushed through a radical
tax reform that slashed income taxes to a flat rate 13pc and later cut corporate
profit taxes to 24pc. Under Boris Yeltsin the government consistently ran a 7pc
to 8pc deficit funded by issuing a never-ending stream of treasury bills, the
notorious GKOs, but under Mr Putin the budget has been in surplus since March
2000. Admittedly, this is partly down to good luck as his presidency has
coincided with high oil prices and the government receives about half its
revenues from oil.

"Putin has provided the forceful leadership that for the first time has
forced Russia to carry out reforms when the cotton is high," says Charles
Ryan, the chairman of United Financial Group, a Moscow-based investment bank.
"In the past they only thought about reforms when the country was in deep
trouble." Macroeconomic growth has averaged 6pc a year, but things have
gone more slowly at the company level. The lack of reforms to things like
bureaucracy and the judicial system has held back foreign direct investment to
about $4 billion a year.

"Direct investment into Russia is still pathetic," says Ryan.
"The paradox is that FDI was higher before the crisis than it is now. The
reason is the lack of reforms mean that investors prefer debt to equity as it
offers better protection against the shenanigans. Last year's FDI was stuck at
about $4 billion, but counting in debt and investment was up to about $20
billion."

However, interest in Russia seems to have reached critical mass and just two
big investments since the start of the year have smashed all records. BP
announced a $6.5 billion deal to buy half of Russia's fourth biggest oil company
Tyumen Oil in January, the single biggest investment into Russia and more than
all foreign investment for the previous three years taken together.

BP was badly burnt in 1999 after it spent $500m on a 10pc stake in Russian
oil major Sidanco, only to see it put into bankruptcy in 1999. Sidanco lost
control of its main production subsidiary and BP had to write off hundreds of
millions of dollars. BP's decision to take a second stab at investing in Russia
has been an enormous vote of confidence and catalysed several other deals.

At the end of April Russia's biggest oil company, Yukos, rushed through a
merger with fifth largest oil company, Sibneft, in a $15 billion union that
catapulted the new company over the likes of British BP, US ChevronTexaco and
French TotalFinaElf into the number two slot in the hydrocarbon universe, in
terms of reserves.

The two companies had already tried to merge in the spring of 1998 and were
still talking about tying the knot but the creation of TNK-BP forced Yukos chief
executive Mikhail Khodorkovsky's hand; Yukos had to act quickly or see Sibneft
snapped up by one of the international oil majors, all of whom were actively
sniffing at Sibneft's skirts.

And only five days ago Royal Dutch/Shell smashed the investment record again,
by announcing it had secured $10 billion of financing to build a gas liquefying
plant on the remote far eastern island of Sakhalin.

"Investors are coming to Russia because of the Russian economic story
and because they are looking for an acceptable return in an otherwise gloomy
global investment climate," says Marcus Hopkins, the head of banking at
Moscow Narodny Bank in London. "But we have been surprised at the speed of
Russia's development."

Oil companies have been driving Russia's growth and rising production has
helped put the country on a solid financial footing. After the break-up of the
Soviet Union, oil production collapsed from a high of 11m barrels a day to
languish at about 6m barrels a day for most of the 1990s. Following the crisis,
oil production began to recover again and has reached about 8m barrels a day
over the first quarter of this year.

Production increases are running at an average of 8pc to 10pc a year and the
leading companies have been putting in double-digit gains for the last two
years.

"Russia's comparative advantage is in the export of raw materials and
commodities are much more profitable than manufacturing," says Peter Boone,
head of research at Brunswick UBS Warburg. "And the companies are taking
this money and reinvesting into Russia, whereas they used to whisk it abroad to
offshore havens."

The 1998 crisis sparked when international oil prices fell to $10, but rising
production means that government already can collect enough tax revenues to
cover expenditures even if oil prices fall dramatically.

"The cost of finding and producing a barrel of oil in Russia is $5, so
even if the price falls to $15 [from the current $25 a barrel] there will be
less money and less investment, but it won't kill the economy," says Boone.

Production increases means that the state-owned export pipeline system is
already working at full capacity and the leading oil companies have been forced
to club together to propose building two new large export pipelines - one to
China and another to north-western port of Murmansk that would open the American
markets to Russian oil.

Oil companies have also fuelled the recovery of the stock market and account
for half the RTS (Russian Trading System) market capitalisation.

Portfolio investors in Russia have had a white-knuckled rollercoaster ride as
they watched the RTS index crash from its all-time high of 572 on October 6 1997
to its all-time low almost exactly a year later of 38 on October 5 1998. But as
Russia has recovered over the last four years the RTS has clawed back most of
the ground lost and the market closed at 437 last week, up by more than a
quarter since the start of the year.

The economic growth has already trickled down to other sectors of the economy
and is being driven by a consumer boom. Small and medium-sized companies are
taking over as the economic engine.

Last year Russian companies raised about $1 billion in corporate eurobonds
but this year they have already issued more than $3 billion of bonds. And the
domestic rouble bond market has doubled every year since 2000. Their next move
is to float on foreign exchanges: 25 Russian companies have already announced
plans to float shares on the London stock market within three years.

However, investing in Russia remains risky. The rule of law is still far
below western standards and the country is extremely exposed to the fluctuations
of the oil price. The bureaucracy is legendary.

The central bank is also struggling to keep inflation in single digits. Mr
Putin pointed out in Friday's speech that most of the economic growth has been
fuelled by the high international oil prices of the last few years and that
reform is still going too slowly.

"In last year's speech, Putin highlighted specific objectives for the
coming year," says Chris Weafer, head of research at Alfa Bank in Moscow.

"One year later, little has changed. In fact, as regards his stated
objectives, there has been no change. Russia's economic health is much improved,
but the risks are still pretty much the same as they have ever been."